Outline the main methods for valuing real estate
The idea
Three approaches are used. The income approach capitalises expected net operating income, either by dividing a stabilised figure by a capitalisation rate or by discounting a forecast cash flow stream. The comparable sales approach adjusts recent transaction prices of similar properties for differences in location, size and condition. The cost approach estimates what it would cost to replace the building, less depreciation, plus land value, and is most relevant for unusual properties with no comparable market. The three rarely agree, and the spread between them is itself informative.
Formulas
Direct capitalisation of a property
value = net operating income ÷ capitalisation rate
- net operating income
- rent less operating costs, before financing and tax
- capitalisation rate
- the yield the market demands on that income, from comparable sales
A perpetuity, so it assumes the income is stable and lasting. The capitalisation rate carries everything the model does not model — location, lease quality, the outlook for rents — which is why it is taken from comparable transactions rather than argued for.
A practice question
What does the income approach to real estate valuation use?
- The property's expected net operating income — correct
- The original construction costWhy not: That is the cost approach, which asks what it would take to rebuild.
- The owner's mortgage balanceWhy not: A financing fact about the owner rather than a property of the building.
An income-producing property is worth the stream it generates. Capitalising or discounting net operating income is the direct expression of that.
A harder one
A property generates stabilised net operating income of 900,000 and the market capitalisation rate is 6%. What is the indicated value?
- 5,400,000Why not: Multiplies the income by six rather than dividing by 0.06, which is a factor of about three too low.
- 15,000,000 — correct
- 54,000Why not: Multiplies the income by 0.06, giving 6% of one year's income rather than a capital value.
Dividing 900,000 by 0.06 gives 15,000,000. The capitalisation rate is a yield, so value moves inversely with it — a rise to 7% would cut the value to under 13 million.
The hardest tier
When is the cost approach most appropriate?
- For a stabilised office building in a liquid marketWhy not: Exactly where income and comparable sales evidence are strongest, which makes them the better approaches.
- For any property financed with debtWhy not: How a property is financed has no bearing on which valuation method fits it.
- For a specialised property with no comparable transactions and no reliable income history — correct
Where neither comparable sales nor a dependable income stream exists, replacement cost less depreciation is the only remaining anchor. It is weakest precisely where the other two are strong.
In the app: 12 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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